A Summer of Love for Europe’s Banks?

August is typically a month of rest in Europe, but as the Continent heads out on vacation, investors should stay put and take a closer look at its financial sector.

By recent standards, last week was triumphant for European Union banks. Several lenders, including a few in troubled Spain and France, released decent earnings. At the same time, Barclays PLC and Deutsche Bank AG, two of the most stubborn opponents to regulatory demands to raise capital, finally gave in. And even British ward Lloyds Banking Group PLC said it would soon start talks with watchdogs over paying its first dividend since 2008.

After being battered and bruised by the deep economic crisis afflicting the region, many EU banks are finally starting to feel better.

The markets have noticed. The Stoxx Europe 600 Banks, an index that tracks 47 large lenders, is up more than 40% over the past year. And some market strategists, such as those at Morgan Stanley, are advising clients to add more European banks to their portfolios, noting that the continent’s financial stocks are cheap relative to other sectors.

Before investors decide whether banks are alluringly cheap or cheap for a reason, they should consider three factors: earnings, balance-sheet quality and the shifting regulatory framework.

On the surface, EU bank earnings are improving. Lenders ranging from Spain’s Banco Santander SA to France’s Société Générale SA and Lloyds have reported strong gains in earnings in recent times. Emilio Botín, Santander’s chairman, summed up the message most banks want to send to the market, saying last week that his bank is “preparing for a new period of profit growth.”

Peeling the onion, though, makes for a less-pretty sight.

A lot of the earnings improvement has been driven by a reduction in the money set aside for loan losses, a sign that corporate and individual borrowers are getting healthier but hardly the stuff of strong profit momentum. Perhaps more worrisome, margins continue to get squeezed; net interest income, the difference between what banks earn on loans and what they pay to fund themselves, is continuing to fall at many lenders—a direct, and painful, result of the low interest rates in the region.

At Santander, for example, net-interest income fell 12% over the previous year. The good news was that this key indicator was up slightly from the first quarter, but analysts question whether that is sustainable across the sector.

“One clear, negative trend emerging from [second quarter] results so far is that NII is generally falling [quarter-on-quarter] and missing consensus,” Nick Anderson, an analyst at the German private bank Berenberg, wrote in a recent note to clients.

If the EU economy really does get out of the recessionary doldrums—and there are some encouraging signs—banks’ top and bottom lines will benefit. The question is whether lenders will be healthy enough to take full advantage of any economic recovery.

Here is where quality of balance sheets—and early actions to clean up house—win out. Think of European lenders as marathon runners and the economic recovery as race day: Who has been training and eating properly? And who has been secretly eating doughnuts and taking shortcuts?

Unfortunately, the latter group is fairly large. Despite the rally in their shares, several banks — Barclays and Deutsche come to mind, but there are others — have been slow in raising capital. Their desire not to hurt shareholders with a deluge of new shares was legitimate. But regulators and investors should have been more forceful in reminding executives that bolstering bank finances is a cornerstone of any rebuilding.

Other lenders, prodded by more-forceful regulators, have moved early to shed unwanted assets and add capital to their balance sheets and should be more prepared to capitalize on any pickup in the economy. Many of the Nordic banks, as well as UBS AG and Credit Suisse AG, belong in this category.

To complicate matters, the regulatory quicksands are shifting. After telling banks for months to focus on a measure of indebtedness based on in-house models of their risks, regulators on both sides of the Atlantic are reversing course. Their new favorite gauge, the “leverage ratio,” is a much more straightforward—and cruder—function of the size of a bank’s balance sheet. The result? European lenders may have to shrink by more than they and their shareholders had thought, reducing the potential for returning cash to investors through dividends or share buybacks.

“European banks still have a lot of issues to work through, the biggest one being leverage,” Philippe Bodereau, head of pan-European credit research at Pacific Investment Management Co., told me. “It’s going to be hard for them to protect their top line and make sure that they make a decent return.”

Europe may be on the beach for the next month or so but investors pondering the fate of its most important sector will have plenty to keep them busy.